w6703-32
Claim 3

Higher volatility of the macro shock, less efficient financial intermediation or lower banks’ cost of funds increase the projects’ risk in a competitive equilibrium.
Proof — see the Appendix electronic-loan.com.
Macroeconomic volatility increases the distortion associated with excessive risk. While macroeconomic volatility does not impact the expected output or the socially optimal risk, higher macroeconomic volatility induces more frequent partial defaults. This in turn leads banks to increase both the lending interest rate and the project’s risk tolerated. The net effect is a rise in “excessive risk”.

The economic rationale is that the repayment in bad states of nature is capped by partial default. Hence, banks will benefit by increasing the risk tolerated and the lending interest rate in the presence of a more volatile macro shock. The greater risk will increase the realized output in good states of nature, whereas the higher lending interest rate charged by banks will shift the repayment towards the good states of nature. This point is exemplified in Figure 5, panel I, tracing the risk as a function of the bank’s cost of funds. The curve is drawn for the parameter values used in Figure 4, panel I. The efficient risk is traced by curve 00. The top 2 curves plot the competitive equilibrium for varying macroeconomic volatility. The top curve corresponds to s = 0.25, and the middle curve corresponds to e = 0 (the absence of macroeconomic volatility).

Applying claim 3′ to result (17) we conclude that, as in the previous discussion, for a high enough cost of financial intermediation, a low banks cost of funds, and significant enough macro volatility, a drop in the bank’s cost of funds is welfare reducing. Macroeconomic volatility magnifies the excessive risk distortion, increasing thereby the range where financial liberalization would be welfare reducing.